The Practice of Capital Budgeting

By:
WAQAR ALI HATTAR 82
AISHA MAHAR 12
NAVEED SOLANGI 60
 CONTENTS

Capital Budgeting Techniques Overview

Capital Budgeting Practices in Chinese
firms
Capital Budgeting Practices in Pakistan
firms
Capital Budgeting Practices in
developing countries
Historical Comparison
 Capital Budgeting Techniques

NON DISCOUNTING TECHNIQUES: DISCOUNTING TECHNIQUES:

1. Average Rate Return /Accounting 1) Net present value (NPV)

rate of return (ARR)
2) Internal Rate of Return (IRR)
2. Pay back period (PBP)
3) Profitability Index
 Non Discounting Techniques

1. Average accounting return (AAR):

The AAR is a measure of accounting profit relative to book value
It is an investments average net income divided by its average
book value.

2. Pay back period (PBP):

The amount of time required for an investment to
generate cash flows sufficient to recover its initial cost.
 Discounting Techniques

1. Net Present Value:

The difference between an investments market
value and its cost.

2. Internal Rate of Return (IRR):

It is the discount rate that makes the estimated
NPV of an investment equal to zero.
3. Profitability Index:
The present value of an investments
future cash flows divided by its initial cost.
It is also called benefitcost ratio.
 Capital Budgeting Practices in Chinese firms

One of the primary goals of this study is to determine

which of the capital budgeting techniques are used by
Chinese firms to evaluate capital budgets. These include
the net present value, internal rate of return, modified
internal rate of return, the profitability index, payback and
the accounting rate of return.
Almost 89 % of the firms indicated NPV was their
primary method.
This was followed by approximately 67 % for the
accounting rate of return, 46 % for the profitability index,
and 41 % for IRR .
surveys find that approximately 83 % of firms used
payback as the secondary technique.
 Capital Budgeting Practices in Pakistan
firms
The information was collected through a questionnaire
from sample companies listed on the Karachi Stock
Exchange (KSE).
The study shows that bigger size companies give greater
preference to IRR, while smaller firms rely more on NPV.
Also smaller firms are keener in estimating the pay back
period (PP) as compared to larger companies.
Consciously or unconsciously the firms relying
more on debt financing or with high growth rates
give more preference to the NPV technique,
while low leverage and low growth firms rely
more on IRR.
Capital Budgeting Practices in developed
countries
As, the capital budgeting practices are the investment decision
taken for increasing shareholders value.
Many studies have been conducted about capital budgeting
practices in U.S. and Europe.
Chadwell-Hatfield et al.(1997) conducted a survey among 118
manufacturing firms in the U.S. Results showed that NPV (84%) and
IRR (70%) were preferred primary methods.
However, it was clearly observed that two thirds of firms relied on
shorter PB periods rather IRR or NPV.
Results were found that NPV was most popular technique, followed
by IRR
Notwithstanding, researchers connotes that small business owners
seemed to be increasingly using DCF as the primary method for
evaluating.
Cont..

In a seminal study of Brounen et al. (2004), four European countries

viz., U.K., France, Germany and the Netherlands consisting of 313
companies during 2002 and 2003 were examined. Their result
showed that 47% and 67% of the UK companies were used NPV
and PB respectively as a primary tool for evaluating capital
budgeting decision whereas companies in Netherlands were used
70% of NPV and 65% of PB methods. However, companies in
France and Germany reported lower usages of both methods (42%
for NPV, 50 % for PB and 44% for NPV, 51 % for PB respectively).
Many researches recognized that DCF is the dominant in
capital budgeting evaluation methods in the UK,the USA
and in Canada1999
NPV, IRR and PB are the most popular methods among
North American and Western European companies.
Cont..

In a survey of capital budgeting practices of Australian

listed companies, Truong et al., 2008 found that NPV,
IRR and PB were the most popular capital budgeting
evaluation methods.
Shinoda (2010) carried out a survey of capital
budgeting in Japan. Questionnaire has been
administered to collect data from a sample of
225 companies listed on Tokyo Stock Exchange.
Results showed that firms were using
combination of PB and NPV for evaluating
capital investment projects.
 Capital Budgeting Practices in
developing countries
In most of the developing countries, PB method was the
dominant methods in evaluating capital investment.
Kester et al.(1999) surveyed a total of 226 companies
across six countries: Australia, Hong Kong, Indonesia,
Malaysia, Philippines and Singapore.
Results showed that PB is still important method and the
DCF methods have become increasingly important.
In five Asian countries, 95% of firms used PB method
and 88% of them use NPV in evaluating projects.
However, both methods were treated as equally
important.
Cont..

(1996) studied Indian industries capital budgeting

practices and the findings showed that 90% of the
companies were using capital budgeting methods. Of
them 75% of companies reported that they were
adopting DCF methods in evaluating capital budgeting,
among them IRR was most popular.
In the Dutch firms, 89% of CFOs reported that they used
NPV methods however, 2% of CFOs stated that they
used the ARR which is the least popular method.
Chinese CFOs stated that they more likely to use NPV
and PB methods (89% and 84% respectively) in
evaluating capital budgeting projects.
Actual Capital Budgeting Practices
Capital Budgeting Techniques in Practice